Does tax really matter when making investment decisions?
Tax rates have been rising for several years now. Personal tax rates have gone up, and even structures such as trusts and companies are now heavily taxed in their own right.
Companies, trusts and individuals are paying almost half of their declared income in tax to the SA Revenue Service (SARS). Currently, an individual at the maximum income bracket is paying ZAc45 in tax for every rand earned. Now, more than ever, tax efficiency makes a material difference to your overall investment return. In fact, any tax saving is equivalent to an increased investment return. So, just how much difference can tax efficiency really make?
Source: PKF Publishers (Pty) Ltd 2018/2019 tax guide
Let’s run two simple R1mn cash portfolios side-by-side. One portfolio is invested in an individual’s hands, in a simple interest-bearing bank account or money market fund. The other portfolio is also invested in the money market but with one important difference – the second portfolio is housed within a retirement annuity (RA). Assume a 30% average tax rate for the individual, with the interest exemption already fully utilised. The growth inside the RA is tax free. Let’s assume a return of 6% p.a. on the investment. So what’s the difference?
In the individual’s hands the 6% p.a. return is reduced by tax to become only a 4.2% after-tax return. The RA earns the full 6% and after one year the tax saving equates to an enhanced return of R18,182 inside the RA. After two years, the saving is R39,690. If you track the two portfolios over a period of 5 years, the RA outperforms the direct investment by R115,625. That amount is nothing to scoff at as it equates to 9.4% more in your pocket at the end of 5 years.
Aren’t there restrictions on my money?
One of the main concerns around structuring investments is the restrictions on your capital – exit penalties, access to capital, increased costs and inadequate reporting are often noted (quite rightly) as investor concerns.
RAs, in particular, have been the focus of many of these queries. Restrictions on access to capital before the age of 55, and limits on underlying investment flexibility, should be clearly understood when housing investments inside an RA.
Tell me about the fees?
As the old adage goes there is no such thing as a free lunch. Structures do have associated fees and the effects of these fees must be assessed against any potential tax savings. Structures such as endowments and RAs have been the subjects of intense scrutiny from modern investors. New-generation products including modern endowments have done a lot to address concerns around fees with exit penalties removed, capital liquidity created through the issue of multiple policies (not applicable to RAs), and drastically reduced fees. These structures now merit a place in an overall investment portfolio.
What about estate duty?
South African tax payers with assets above the R3.5mn exemption are subject to estate duty (death taxes) at a flat rate of 20% currently. It is important to realise that your beneficiaries will only receive their inheritance after your estate has settled its bill with SARS. Without proper planning your estate could be handing the tax man up to one-fifth of all your assets. As daunting as this may seem there are tools available for estate-planning purposes.
A simple, and zero-cost, method of reducing estate duty is to leave assets to your surviving spouse. Any assets left to your spouse are currently exempt from estate duty and this preserves the R3.5mn tax exemption which can be used later in your spouse’s estate. This means that, upon death, your spouse will benefit from a full R7mn estate duty exemption (the R3.5mn exemption x 2).
Do you have any assets held offshore? If so, beware of offshore death taxes such as situs tax. This is a tax levied for assets held offshore such as property and equities. The thresholds before this tax applies differs from country to country. The UK, for example, allows the first GBP325,000 free of inheritance tax. In the US the first $60,000 is exempt. The balance in both cases is then taxed at a flat 40% rate – double SA’s estate duty.
Again, there are tools available to address this issue. Investing within an offshore insurance wrapper, for example, has the advantages of not attracting situs tax, even while holding the same underlying taxable assets – that is a 40% boost to your heirs on death! Beneficiary nominations on these structures will also assist further by avoiding executor fees (another 4% saving).
So which structure is the right one?
For simple investing, often a single structure may be appropriate. More complex portfolios may require several structures including trusts, companies, endowments, RAs etc.
An important note around any investment structuring is to update your will as required. There may even be a need for two wills – one for your local assets and one to deal with any assets held offshore. Specialist advice should always be sought, as required. It is essential for any structures to correctly reference any affected assets and to take cognisance of applicable legislation and taxes in the relevant jurisdictions.
To whom should I be talking?
Ideally, your accountant, legal counsel (where applicable) and wealth manager should be aware of any structural changes to your portfolio.
It is every taxpayer’s right to structure their affairs and investments in the most tax-effective manner possible. Tax is never the sole consideration but instead forms part of the overall investment plan.
Smart tax planning is just good investment sense, and will affect your returns over the long term.
Disclaimer: The contents of this article is for information purposes only and the accuracy, completeness, timeliness, or correct sequencing of any of the information contained herein cannot be guaranteed and should thus not be construed as investment advice. Readers should thus only act thereon after having consulted their financial adviser.